Optimal Chinese Monetary Policy Under Low Global Interest Rates

Transcription

1 1 / 33 Optimal Chinese Monetary Policy Under Low Global Interest Rates Chun Chang 1,Zheng Liu 2, and Mark M. Spiegel 2 1 Shanghai Advanced Institute of Finance 2 Federal Reserve Bank of San Francisco March 22, 2012 Note: Paper prepared for conference on "Monetary Policy in a Global Setting: China and the United States," Tsinghua University, Beijing, China, March The views expressed are those of the authors and do not necessarily represent those of the Federal Reserve Board of Governors or the Federal Reserve Bank of San Francisco.

2 Introduction 2 / 33 Due to capital account restrictions, famous "trilemma" argument does not apply rigidly to China However, capital account not completely closed Specific policies towards exporters Swap foreign receipts with the central bank at par values "Self-imposed" addition to the leakages in capital account Could either refuse unlimited repatriation of export revenues, or swap at rate other than par Either response would reduce export activity, which appears undesirable to policymakers

3 Optimal Sterilization Intensity in China 3 / 33 Evaluate optimal sterilization policy in China Take "other policies," as given Capital account regime Swaps of foreign receipts for domestic assets at par Exchange rate policy Derive optimal policy in response to both negative world interest rate shock and foreign demand shock

4 Negative shock to Global Rate Mirrors Crisis Experience 4 / 33 Consider negative shock sufficient to reverse sign of difference between domestic and foreign interest rates In early part of previous decade, China rates often below those earned on foreign bonds Implied marginal fiscal benefits to sterilization [e.g. Prasad and Wei (2007)] After crisis, elevated Chinese rates, combined with low rates in developed economies, have reversed pattern Now positive spread between Chinese domestic rates and international assets True for both CHIBOR and SHIBOR, but also for China CB paper vs US Treasury [Huang (2010)] Most recently, spreads of SHIBOR over comparable Treasuries have increased to over 500 basis points

5 Chinese rates are now higher than those in Western Economies 5 / 33 Chinese Interbank vs. US Government Bond Yields 3 month maturities Percent SHIBOR US Govt Bond Source: Bloomberg

6 Chinese Situation Now Closer to Traditional "Quasi-Fiscal" Cost Literature 6 / 33 Calvo (1991): Sterilization with higher domestic rates lead to "quasi-fiscal" costs Interest rate premia on domestic debt relative to foreign bonds Historically, costs have been substantial Latin America: 0.25 to 0.5 percent of GDP [Calvo, Leiderman, Reinhart (1996)] Asia: 0.25% [Kletzer and Spiegel (1998)]

7 Closed Capital Account Distinguishes China from Early EME Literature 7 / 33 Early estimates of fiscal costs of sterilization calculated ex-post in the absence of government defaults Ex-ante, given open capital accounts, uncovered interest rate parity should equalize expected domestic and foreign asset returns In contrast, China s closed capital account allows deviations from uncovered interest parity Observed deviations between domestic Chinese and foreign bonds represent true expected costs of sterilization Default risk likely minimal for both assets China s sterilization costs therefore true "fiscal costs," rather than "quasi-fiscal costs"

8 Foreign Reserves Have Increased Dramatically 8 / 33 Foreign Reserves as a share of Total Assets Percent Foreign Reserves/Total Assets Source: PBOC 40

9 Is Sterilization Becoming More Difficult for China? 9 / 33 "Offset coefficient," fraction of change in monetary base that is offset by international capital movements, has grown over time [Ouyang, et al (2010), Huang (2010)] Indicator of the openness of the Chinese capital account Implies more intensive sterilization activity required to meet exchange rate targets Attitudes towards capital controls have also become more agnostic [e.g. Ostry, et al (2010)] Some argue capital controls in China facilitate exchange rate flexibility [e.g. Prasad, et al (2005)]

10 This paper Evaluates Optimal Sterilization Policy in Fully-specified DSGE Model 10 / 33 We consider a sticky price two-country model consisting of China and the rest of the world. Treat China as "small," in sense that rest of world (ROW) does not respond to Chinese conditions Monopolistically-competitive retail goods sector in which China and the rest of the world have market power in the varieties that they produce Retail goods inputs into perfectly-competitive final composite good Solve the model and derive optimal policy

11 Benchmark Model Takes Prevailing Chinese Policies as Given 11 / 33 Government accommodates exogenous target for exchange-rate appreciation rate Central bank (CB) sterilizes current-account surplus by exchanging domestic bonds for foreign currency bonds Swaps at prevailing market prices Private sector not allowed to hold foreign assets Authorities value domestic interest rate smoothing Short-hand way to say committed to export subsidy In absence, CB could adjust domestic rates to offset foreign shocks and regain steady state solution Would reduce transfer to export sector Did not observe such a response in SHIBOR rates

12 Examine monetary policy reaction to shocks to foreign interest rates and export demand 12 / 33 Foreign interest rate decline analogous to Western economies during crisis Demonstrate that optimal policy incorporates increased sterilization costs Given exchange rate appreciation target, corresponds to allowing increase in money supply and inflation Positive shock to foreign export demand Given sticky prices, raises output and inflation Monetary authority tightens policy by raising rates Increases spread between domestic and foreign rates, raising sterilization costs In response, CB again reduces sterilization activity, increasing money growth and inflation

13 Benchmark model Two countries home and foreign Home country Continuum of identical and infinitely-lived households Representative household consumes final good, holds real money balances, and supplies labor to firms Final good is composite of differentiated retail products Retail products produced using labor and intermediate goods Intermediate goods composite of domestic and imported materials Final goods can therefore also be used as intermediate input or exported to the foreign country All markets except retail products are perfectly competitive Market for retail products is monopolistically competitive Price adjustments are costly 13 / 33

14 Government behavior broadly consistent with current Chinese institutional features 14 / 33 Government maintains desired rate of exchange-rate appreciation Sterilizes current-account surplus by exchanging domestic bonds for foreign bonds Transaction takes place at par market values Government wishes to support the export sector For simplicity, achieve this by adding a desire to smooth domestic interest rates into the monetary authority s loss function In absence, would not get dynamics, as CB would simply adjust money supply to offset foreign interest shock Subject to these restrictions, monetary authority chooses optimal policy

15 The aggregation sector 15 / 33 Production of composite final good requires continuum of differentiated retail products {Y t (j)} j [0,1], with aggregation technology Y t = [ 1 0 ] ɛ Y t (j) ɛ 1 ɛ 1 ɛ dj, (1) where ɛ > 1 is elasticity of substitution between retail goods Demand for the retail good is given by Y d t (j) = [ ] Pt (j) ɛ Y t, (2) P t

16 Household sector 16 / 33 Representative household chooses consumption C t, money balances M t, labor hours L t, and domestic bond holdings, B t to maximize life-time expected utility: U = E { } β t ln (C t χc t 1 ) + Φ m ln M t ψ L1+η t, (3) P t 1 + η t=0 subject to the sequence of budget constraints C t + M t + B t w t L t + M t 1 B t 1 + R t 1 + D t (4) P t P t P t P t P t taking P t, R t 1, and w t as given

17 Retail sector 17 / 33 There is a continuum of retailers, each producing differentiated product Y t (j) under constant returns technology Y t (j) = Γ t (j) φ (Z t L t (j)) 1 φ, (5) where Z t is labor-augmenting technology shock, Γ t (j) denotes input of intermediate goods, and L t (j) denotes labor input

18 Retailer optimization problem 18 / 33 We follow Rotemberg (1982) and consider the quadratic price adjustment cost ( ) Ω Pt (j) 2 2 πp t 1 (j) 1 C t Retailer then solves the problem [ ( ) Max Pt (j) E t β k C t Pt+k (j) v t+k Yt+k d C k=0 t+k P (j) Ω ( ) ] Pt+k (j) 2 t+k 2 πp t+k 1 (j) 1 C t+k, (6) where Y d t (j) is demand for good j and v t represents real marginal cost

19 Intermediate goods sector 19 / 33 Intermediate goods are used by retail sector Composite of domestically produced and imported goods Γ t = Γ α ht Γ1 α ft, (7) where Γ ht and Γ ft denote domestic and imported goods Cost-minimization implies that q t e tp t P t where q t is the real exchange rate. = 1 α Γ ht, (8) α Γ ft

20 External sector and current account Current account is given by ca t = X t q t Γ ft + e t(r t 1 1)B t 1 P t, (9) Export demand satisfies X t = ( Pt e t P t ) θ X t Z p t = qt θ X t Z p t, (10) where X t is foreign aggregate demand, which follows exogenous process ln X t = (1 ρ x ) ln X + ρ x ln X t 1 + σ x ε xt (11) 20 / 33

21 Government policy and sterilized intervention 21 / 33 Government allows the nominal exchange rate to appreciate at target rate γ e and maintains closed capital account Private sector not allowed to hold foreign assets Government buys up any net inflow of foreign assets from the private sector using domestic currency Sterilizes purchase by swapping domestic-currency bonds for money with the private sector When sterilization is costly, government may choose to only partially sterilize Let S t [0, 1] represent the intensity of sterilization: S t B t B t 1 P t ca t. (12)

22 Sterilization Costs 22 / 33 We measure the fiscal costs of sterilization, FC t, relative to the current account as FC t = 1 [ B t B t 1 e t+1 R ] t e t (Bt Bt 1 P t ca t e t R ) = S t e t+1 Rt, t e t R t (13) Intuitively, costs equal to difference between cost of swapping domestic for foreign bonds and present value of holding inflow of foreign capital Function of intensity of sterilization S t, and deviation from uncovered interest parity Government flow-of-funds constraint satisfies e t (B t R t 1 B t 1 ) B t R t 1 B t 1 + M s t M s t 1 (14)

23 Market clearing and equilibrium 23 / 33 Equilibrium is sequence of prices {P t, w t, q mt, e t, R t } and aggregate quantities {C t, Y t, Γ t, Γ ht, Γ ft, X t, L t, M t, M s t, B t}, as well as the price P t (j) and quantities {Y t (j), L t (j), Γ t (j)} for each retail firm j [0, 1] such that: Prices and allocations for each retail firm solves profit-maximizing problem Allocations for the representative household solve the household s utility maximizing problem Markets for final goods, intermediate goods, labor, money balances, and bond holdings all clear

24 Optimal monetary policy 24 / 33 Policymaker minimizes quadratic loss function subject to the private sector s optimizing conditions. We consider the loss function L = L t, t L t = λ πˆπ 2 t + λ y ĝdp 2 t + λ bˆb 2 t + λ r ˆR2 t, (15) Inflation and output terms are standard ˆb t captures desire to avoid large fluctuations in foreign reserves Hard to sell or buy foreign assets without affecting world prices ˆR t reflects CB desire to maintain prevailing domestic interest rate to insulate exporters interest income from foreign shocks Ramsey planner optimizes subject to log-linearized conditions

25 Calibration: Household preferences and technology 25 / 33 Model is quarterly Set β, subjective discount factor, to consistent with literature Labor supply We set η = 2, so that Frisch elasticity of labor supply is 0.5 [e.g. Pencavel (1986)] Choose ψ so that steady-state labor hours equal to about 40 percent of the time endowment Technology Set cost share of intermediate goods to φ = 0.5, consistent with US input-output tables Set the mean technology growth rate to λ z = 1.02, so real per capita GDP grows at 8% annual rate on average, similar to China

26 Calibration: Nominal rigidities and external sector 26 / 33 Nominal rigidities ɛ = 5: steady-state markup 25% Ω = 30: slope of the Phillips curve about 0.08, same as Calvo model, with re-optimized prices every 4 quarters. External sector α = 0.7: import-to-gdp ratio 20% in steady state, equal to the average ratio in China 1990 and 2009 θ = 1.5: export demand elasticity same as the elasticity of substitution between home goods and foreign goods in Backus, et al (1994) Between China and US elasticity of export demand likely to be small. Results are robust to range of values

27 Dynamic responses to foreign interest rate and demand shocks 27 / 33 Dynamics are deviations from steady state In steady state, domestic nominal interest rate slightly lower foreign nominal interest rate R = : Annual rates of returns of 3 percent on domestic bonds R = 1.01: Annual rates of returns of 4 percent on foreign bonds Higher Chinese rate captures low yields due to control of financial sector [e.g. Prasad and Wei (2007)] Calibrate steady state to set net exports to about 3 percent of GDP, similar to China from 1990 to 2009 Note that there is a positive steady-state trade surplus and foreign capital inflow, which are constant shares of GDP

28 Negative foreign interest rate shock 28 / 33 Examine a decline in R to capture the effects of the recent global financial crisis Leading central banks, such Federal Reserve, ECB, and Bank of Japan eased monetary policy aggressively Monetary easing was persistent Fed conducted 2 rounds of quantitative easing policy Also kept short-term nominal interest rate at zero since 2009, and announced that it expects to continue 0 rate through the end of 2014 We therefore make R shock highly persistent by setting ρ r = 0.95

29 Impact of negative foreign interest rate shock 29 / 33 Decline in R, combined with reluctance to reduce domestic rates to protect exporters, raises the cost of sterilization for the Chinese government Ramsey planner responds by reducing sterilization and aggressively cutting back on domestic debt Requires planner to let money supply rise to finance the purchases of foreign capital inflows from the private sector Increase in money growth leads to short-run expansion in domestic aggregate demand and consumption Cushions the negative effects of the foreign interest rate shock, and despite decline in current account surplus, real GDP rises in short run Over time, persistent real exchange rate appreciation restores current account to steady state

30 Impulse responses following a persistent decline in the foreign interest rate 30 / x 10 3 Real GDP 2 x 10 3 Domestic inflation Current account 0 x 10 3 Nominal interest rate Real exchange rate Domestic debt

31 Impact of positive foreign demand shock 31 / 33 Increased foreign demand leads raises current account and induces inflows of foreign capital Given sticky prices and nominal exchange rate target, raises GDP and inflation Leads to real exchange rate appreciation, which constrains further increases in the current account and helps bring it back to steady state Planner responds to initial shock by tightening monetary policy through an increase in the nominal interest rate Raises the cost of sterilization Planner thus does not sterilize inflows in short run Domestic debt stock unchanged (even declines modestly) Over time, foreign demand shock dies out, inflationary effect wanes and nominal interest rate declines back to steady state Reduces cost of sterilization Planner raises domestic debt to absorb foreign capital inflows

32 Impulse responses following a positive foreign demand shock 32 / 33 2 x 10 3 Real GDP 4 x 10 4 Domestic inflation Current account x 10 5 Nominal interest rate x 10 3 Real exchange rate x 10 4 Real domestic debt

33 Conclusion 33 / 33 Examine optimal monetary policy given prevailing Chinese capital controls and exchange rate policies Optimal monetary policy responds to sterilization costs Given negative shock to relative foreign interest rates optimal policy calls for a reduction in sterilization activity, resulting in easing of monetary policy and increase in Chinese inflation Results unique to China as capital controls break UIRP Similar to current situation in wake of global financial crisis Increase in foreign export demand also results in less-intensive sterilization activity, and implies easing of optimal monetary policy Future extensions Consider welfare implications of easing capital account and exchange rate policies Also Implications of regime changes on the dynamics associated with foreign shocks